Trading Earnings: A Tale Of Two Strategies

So despite my 152% ROI in 2012, I really wanted to know why my approach doesn't work. Maybe it was all just a fluke?

The article finally came out last week, but it had nothing to do with my trading approach. It was all about my personal history with Kevin which I don't think is much of an interest to our readers. My article is strictly about my trading approach and how it compares with Kevin's.

First, let me be very clear: no matter what some "gurus" will tell you, no strategy will work all the time. Mine is no exception. I never claimed that it works under all market conditions, and I never claimed that other strategies won't work and mine is the only right thing to do. There is more than one road to Rome.

My approach

I described my strategy of trading earnings here and here. The strategy is buying a long straddle or Reverse Iron Condor a few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings.

Now, few scenarios are possible.

1. The IV increase is not enough to offset the negative theta and the stock doesn't move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days, and the maximum risk is around 20-25% (except for some very rare cases).
2. The IV increase offsets the negative theta and the stock doesn't move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners, sometimes in the 50-60% range.

What I really like about this strategy is the ability to keep the losses small. The risk/reward is significantly smaller than most other options strategies. Overall, the average gain is in the 10-15% range and the average loss in the 5-10% range. Combined with decent winning ratio of ~60%, the strategy should be a winner in the long term.

In some cases, when I think that near term options are overvalued, I might also buy a calendar spread with short options expiring just after earnings.

Kevin's approach

Kevin also likes to trade earnings non-directionally, but with one significant difference: if the trade doesn't produce significant gains before earnings, it will be held through earnings. In my opinion, this strategy has negative long term expectancy because on average, options tend to be overpriced before earnings and IV collapse after the earnings will cause the trade to lose value - unless the stock moves more than implied by the options prices. I described here why I don't like to hold those trades through earnings.

Same is true with calendar spreads - if you hold a calendar spread through earnings, you bet that the stock will not move much. If it does, the loss can be catastrophic, as proved by Kevin's IBM trade.

The main problem of holding any trade through earnings is complete lack of predictability. Some trades can produce outstanding gains while others end up with catastrophic losses. If the trade uses short expiration and the stock moves less than "predicted" by the options prices, the collapsed IV will cause a very significant loss.

How position sizing impacts the overall performance

The most important point that many traders ignore is the position sizing. Even if the second strategy (holding through earnings) produces higher average gains (and I doubt it), what really matters is how much your overall account gains. When you risk only 20-25% per trade worst case, you can easily allocate 10% per trade. However, when you hold through earnings, your risk is up to 90-100%. That means that realistically, you cannot allocate more than 2-3% per trade. If you allocate 10% and you have a streak of 4-5 big losers, you have just lost half of your account. Whoever claims never having such a streak is either lying or hasn't been trading for long enough.

Kevin keeps saying that he "doesn't trade options for a 5% ROI". Let's check what 5% return can do to your account.

Assuming that you make 20 trades per month, allocate 10% per trade and make 5% per trade, your overall account grows 10% per month. Commissions will reduce it to ~7-8% per month. That's about 80-90% per year, non-compounded (while having ~40% of the account in cash). Increasing the allocation to 15% will produce 120-140% annual return while still risking only 3% per trade. I challenge Kevin to show how he can achieve a similar return with his strategy with similar level of risk. I also challenge him to show any kind of statistics for his strategy of holding through earnings.

Here is another point that many traders miss. If you have a 15% loser and two 15% winners, that's 5% average return. But if you take a 100% loser, it will take two 60% winners or three 40% winners to produce similar 5% average return.

Conclusion

To conclude, it all comes to what kind of trader you want to be. Is your goal to limit the losses or to maximize the gains? You cannot have it both ways. Higher gains come with higher risk and inevitably will produce some big losers, so the position sizing has to be adjusted accordingly. Risk and reward are closely related in trading.

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